Target Brands: Both the Best and the Worst Alternative Apportionment Analysis Yet

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Tax Policy

Bloomberg BNA regularly spotlights the insights of state and local tax attorneys at Alston & Bird LLP. In this installment, Clark Calhoun and Matthew Hedstrom discuss a recent Colorado case that looked at the design and intent of the state's apportionment formula, found that by design it did not capture the taxpayer's income because the taxpayer's business activities occurred out-of-state, yet allowed the state to invoke alternative apportionment to capture some of the taxpayer's income.

Clark R. Calhoun Matthew Hedstrom

By Clark R. Calhoun and Matt P. Hedstrom

Clark Calhoun, partner at Alston & Bird LLP, represents clients in state and local tax controversy and litigation matters. Matthew Hedstrom is a partner focusing on state and local tax planning and controversy in Alston & Bird LLP's New York office.

For as much attention as alternative apportionment has received in recent years, there is still a surprising shortage of meaningful analysis of the circumstances under which a state's apportionment provisions “do not fairly represent the extent of [a] taxpayer's business activity” within the state, such that the use of alternative apportionment is appropriate. [ See Uniform Division of Income for Tax Purposes Act (“UDITPA”), §18.] The frequently-cited decisions from the 1970s and 1980s mostly contain recitations of the facts, followed by the court's conclusion that the state's standard apportionment formula—which was almost always the traditional three-factor formula—did or did not “fairly represent” the taxpayer's “business activity” in the state. [ See, e.g., Sears Roebuck & Co. v. State Tax Assessor, 561 A.2d 172 (Me. 1989); Deseret Pharm. Co. v. State Tax Comm'n, 579 P.2d 1322 (Utah 1978); St. Johnsbury Trucking Co., Inc. v. State, 385 A.2d 215 (N.H. 1978); Donald M. Drake Co. v. Dep't of Revenue, 500 P.2d 1041 (Or. 1972).] More recent decisions have been similarly short on analysis regarding the factors that demonstrate whether a taxpayer's in-state business activity is “fairly represented” by a state's standard formula. [ See, e.g., Equifax, Inc. v. Miss. Dep't of Revenue, 125 So. 3d 36 (Miss. 2013); Union Pacific Corp. v. Idaho State Tax Comm'n, 83 P.3d 116 (Idaho 2004).] A particular problem in many courts' alternative apportionment analyses has been a failure to analyze the taxpayer's actual “business activities” in the state (as required by the statute), instead conflating that term with the taxpayer's in-state “receipts.” [ See, e.g., Vodafone Americas Holdings, Inc. v. Roberts, 486 S.W.3d 496 (Tenn. 2016) (reasoning that if the taxpayer were able to apply the standard costs-of-performance formula, “billions of dollars in Vodafone's revenue from Tennessee customers would become invisible for tax purposes”) (emphasis added).]

Three-Factor Formula

The analysis provided by a Colorado district court in its January decision in Target Brands [ Target Brands, Inc. v. Dep't of Revenue of the State of Colo., Case No. 2015CV33831 (Colo. Dist. Ct., Denver, Jan. 27, 2017).] is a meaningful step in the right direction. Unlike many other court decisions on the issue, the Colorado district court discussed the taxpayer's “business activities” at length to determine whether those activities were “fairly” represented by the state's standard apportionment formula. Target Brands is the entity formed by Target Corporation (“Target”) to manage and license the group's intangible property. During the audit period, Colorado used a three-factor formula, and Target Brands had no property or payroll in the state. Target Brands had significant property and payroll outside the state, in Minneapolis (where personnel performed a number of activities to maintain, develop, and protect Target's intellectual property) and in other cities within and outside the United States. Accordingly, under Colorado's standard sales factor, under which a taxpayer's gross receipts are sourced to Colorado “if a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance,” Target Brands also had a zero sales factor. [ Id. ¶ 61 (citing Colo. Rev. Stat. §24-60-1301).]

The court recognized that this costs-of-performance (“COP”) formula was not a “market-based” formula, and it explicitly noted that all of Target Brands' “income-producing activities” occurred outside the state. Further, it added that the COP formula was not intended to capture a taxpayer's in-state receipts: “This ‘greater proportion’ analysis, by design, does not apportion receipts from intangible property or services to the location where the property/services are utilized or received.” [ Id. ¶ 61 (emphasis in original).] The Colorado court thus became the first to explicitly recognize what should be obvious: if the statutory formula works exactly as intended with respect to a taxpayer, that should point strongly toward concluding that the standard formula “fairly represents” the taxpayer's in-state business activities—because there is nothing “fair” about imposing taxes upon an isolated taxpayer through alternative apportionment when the legislature expressly chose not to impose tax upon all taxpayers with that fact pattern. [ See ¶ 70 (“Strict application of tax measures has been called a fundamental precept that protects citizens by informing them in unambiguous terms about the amount and nature of their duty to pay taxes.”); id. (“All doubts will be construed against the government and in favor of the taxpayer.”) (citations omitted)] This is especially true in the context of a COP formula, where the taxpayer must source all of its receipts to the state if it performs 51% of more of its “income-producing activities” there.

Alternative Apportionment Analysis

The court even noted that a number of states had considered the application of their standard formulas to a licensor of intangible assets like Target Brands and modified their sales factors “to source income from intangibles under a market-based approach,” either via statute or through promulgation of an industry-specific regulation. [ Id. ¶ 69.] In recognition of that option that was plainly available to the state, the court added that it was “ disinclined to permit the Department to accomplish indirectly [via the use of alternative apportionment] what neither it nor the General Assembly could have done, but did not do, directly and expressly.” [ Id. ¶ 70 (emphasis added).] While it covers only a few pages, the Colorado district court's discussion of the threshold application of alternative apportionment is perhaps the most comprehensive and cogent alternative apportionment analysis ever performed by a court, as it is the only court to have addressed both the intent/design of the standard formula as well as the state's ability to apply a different standard formula through the traditional—and transparent—means of amending the state's written laws.

It is therefore remarkable that—despite its inclination—the court upheld the state's right to utilize alternative apportionment, writing that the purpose of alternative apportionment would be negated if it could not be applied “when the Department arguably was slow to recognize” the circumstances under which an adjustment to the standard formula was needed. [ Id.] That is, despite its recognition that the COP statute did not capture Target Brands' in-state receipts “by design,” and despite its caution against permitting the Department to use alternative apportionment to impose tax in circumstances where the legislature and Department had chosen not to make a broader policy change, the court still upheld the Department's right to use alternative apportionment. In support of that conclusion, it cited four reasons:

  • (1) the Department had not previously taken any case regarding the income tax of an intangible holding company (“IHC”) to an administrative hearing;
  • (2) even those IHC cases that had been litigated previously had occurred “in the last four or five years”;
  • (3) the court was not aware that any of those IHCs were “80/20” companies (i.e., companies with 80% or more of their payroll outside the United States); and
  • (4) as noted above, a taxpayer's in-state receipts should not escape state taxation altogether just because the state was “slow” to act at the legislative or regulatory level. [ Id. ¶¶ 66-69.]

Unfortunately, then, after its thorough analysis of the reasons for triggering alternative apportionment, the court contradicted itself, finding that alternative apportionment was necessary to capture some of Target Brands' income in the state, even though its “activities” occurred outside the state. The court goes on to make the same mistake that the Vodafone court made, finding that an admittedly common fact pattern—a service provider in Vodafone, and an IHC in Target Brands—was “unusual” simply because it had not been litigated as an alternative apportionment case before. [ Vodafone, 486 S.W.3d at 528-29; Target Brands, Case No. 2015CV33831, at ¶ 66.] Whether a specific fact pattern has been litigated is not the standard for assessing an “unusual fact situation,” much less whether the apportionment formula “fairly reflects” the taxpayer's “business activities” in state.

Best Analysis, Worst Analysis

Taken together, the Colorado district court's analysis of the circumstances under which alternative apportionment is appropriate was both the best analysis of any court to date (because of its relatively lengthy and cogent discussion of the reasons why invoking alternative apportionment is or is not appropriate) and the worst analysis to date, because the court affirmed the use of alternative apportionment, even when it recognized that (a) the standard COP sales factor “by design” did not source any of Target Brands' in-state receipts to Colorado and (b) the Department was “slow to recognize” the potential effects of a common fact pattern addressed by numerous other states.

Finally, it must be noted that the court saved itself to a degree by rejecting the state's attempt to impose a single sales-factor formula on Target Brands (using Target's sales factor) as a “reasonable” alternative apportionment formula. [ Target Brands, Case No. 2015CV33831, at ¶ 73-75.] Instead, the court held that it would not be “reasonable” or “equitable” to exclude Target Brands' payroll and property factors, since those factors contributed materially to its generation of income. In the face of continued abuse of alternative apportionment provisions by state tax authorities, a meaningful discussion of “reasonableness” – as opposed to a court's simply giving lip service to the Department's proposed adjustment – is a welcome breath of fresh air. But while that conclusion was a modest victory for Target Brands, it did nothing to undo the harm caused by the court's erroneous holding on the threshold issue, after the court had done so well to explain the reasons why the use of alternative apportionment was not appropriate in the first place.

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